For a brief period this month an electronic form of currency called bitcoins were all the rage. Promoted as an alternative to paper or "fiat" currency, bitcoin caught a popular wave with the public and became the it investment of the moment. With high profile investors like the Winklevoss twins, it seemed like nothing could stop the momentum.
Then as quickly as it inflated, the bitcoin bubble burst. After rising from $20 in February to $266 on April 10th, bitcoin crashed on April 11th, dropping more than $100 before trading was halted. The crash took the price of a bitcoin down more than 75% from its highs to the lows. As usual, it's the latecomers who are getting hit with the biggest losses.
Bitcoin will make a nice cautionary tale someday, but so do stories of the housing bubble, the Internet bubble, and every collapse since Dutch Tulips in the 17th century. Some even say the decline of Apple (AAPL) shares and gold's recent price slide are indicative of modern-day bubbles.
If the masses could really learn anything from these disasters then bubbles would be a thing of the past, rather than regular occurrences. Most people just can't help themselves when tempted with the prospect of easy money.
That doesn't mean you have to be the next victim of a bubble mania. In this edition of Investing 101, Robert Luna of SureVest walks us through 5 signs of an investment bubble.
1) Valuations deviate significantly from a long-term historical average
Luna points to the housing bubble as an example of assets with established valuation metrics getting woefully distorted. Decades of conventional wisdom suggests the "right" amount to spend on a house is about 3x annual income. When people started quiting their real jobs and buying 2 or 3 houses on margin, it was a sign things weren't going to end well for houseflippers.
2) Analysts begin making outlandish predictions as assets hit new highs
Dow 36,000. Apple (AAPL) hitting a trillion dollar market cap. Bitcoin becoming the world's global standard for currency. All are examples of the kind of predictions that get made at the top of an investing cycle, not the bottom.
The prognostications seem like lunacy in retrospect, but were conventional wisdom, if only for a moment. Remember: Splashy predictions get headlines but slow and steady wins the race for investors.
"When you start hearing those things after a big a move in a stock, whatever asset class it may be, usually is a tell-tale sign to head for the exits," says Luna.
3) Everyone and their mother is the new expert on investing in this asset class
Luna notes that "every waiter" seemed to quit their job to become a day-trader in 1999 or a realtor in 2005. When making money seems so easy that amateurs start quitting their day jobs to make real money competing against professionals, it's a good clue that a bubble is forming.
4) People believe that “this time is different”
This time is never really different.
5) Political manipulation, unsustainable asset catalysts
It's no coincidence bitcoin's popularity came at a the same time the meltdown in Cyprus was making fools of the world's Central Banks. When political forces start impacting one group of assets, bubbles pop up to fill whatever voids are left behind. Gold became a bubble because currency was manipulated. Bitcoins popped up because Cyprus made it look as though no form of "real" currency would be safe.
The odds never favor a political or policy-driven rush into assets being sustainable. Eventually the free market wins out, and when it does, bubbles violently deflate, leaving financial disaster in their wake. That doesn't mean you have to be one of the victims. Learn from history and recognize bubbles in real time.